Koichi [Hamada] cited our late colleague Mike Mussa, who of course in addition to being brilliant, was the master of the quip and he at one point had said, “Putting Alan Greenspan in charge of bank supervision was like putting a conscientious objector in charge of the Marine Corps.”

Governor Shirakawa or Governor Hayami as head of an expansionary monetary policy is the same thing. They both took office and insisted that they could not do anything and that any attempts they made would fail and that when they made attempts that their heart wasn’t in it and it was contrary to their principles and it would only prove that their attempts would fail. Now, monetary policy is not merely a confidence game, but this meant that at every level throughout the BOJ and every time there was an innovation or an attempt at new policy, the governors themselves were undercutting it.

I have edited out a couple of errors in the transcription…. central bankers who insist that they cannot “do anything”, and anyway “doing something” would be a really bad idea? Does that sound familiar?

There’s a presentation from Abe’s adviser Koichi Hamada in there too (slides here), though it is a little hard to follow. He says the stock market rally and Yen devaluation since November disprove the arguments of those who argue “monetary policy doesn’t work” (right on), and also debunks the “currency war” rubbish; what would be really damaging is trying to align Japanese monetary policy with the needs of the American economy, rather than the domestic economy of Japan.

2012 saw the second lowest annual nominal GDP growth on record, after 2009. Here are annual data for the last five years, as usual showing both market prices (GDP) and basic prices (GVA) to highlight the impact of indirect tax changes which push up the former:

The forecast data from the February Inflation Report is out. The CPI forecasts have been revised upwards right across the forecast period, particularly sharply in the near term. Here’s how the forecasts have developed over the last four quarters:

Bank of England Median CPI Forecasts

The Bank is for the first time since 2008 forecasting CPI inflation significantly above 2% on the two year horizon – 2.3% to be exact.

We can split out the forecast on the two and three year horizon for context. Each point on this chart gives the contemporary forecast looking two years (blue line) and three years forward (green line):

25. Inflation was likely to rise further in the near term and could remain above the 2% target for the next two years, reflecting sterling’s recent depreciation and the persistent contribution from administered and regulated prices. That persistent contribution was likely to be increasingly offset by a gentle moderation in domestic cost growth, aided by a gradual revival in productivity growth, and an easing in external price pressures, such that inflation was likely to fall back to around target by the end of the forecast period. The outlook for inflation over much of the forecast period was higher than in the November Inflation Report, reflecting the impacts of administered prices and the lower exchange
rate.

What is more interesting is that no less than three MPC members (King, Fisher, Miles) voted for an extension of QE at the February meeting despite this forecast for CPI above 2%.

This seems like quite a shift in the Bank’s reaction function. It is worth contrasting February 2013 with May 2012 when MPC hawks were on the rampage despite below-target CPI forecasts, or Spring 2011 when the MPC came close to a rate hike with the CPI forecasts were roughly on target.

Or we could go back to early 2010, when the MPC did not try to offset the supply-side price shock when Darling allowed VAT to return to 17.5%, stopping the original QE programme in January that year as this took effect. The MPC could easily have used this same type of “administered and regulated prices” excuse to ensure the VAT rise did not compress net prices below 2%. Instead we got CPI at constant taxes rising just 1.5% in 2010. (Memo to Ed Balls: it is hard to imagine a worse way to try to boost UK aggregate demand than hoping the MPC plays along nicely both after and during a temporary VAT cut.)

Since about mid-2011, the Riksbank has turned from the bold imposer of negative interest rates, to the timid, fretting institution we know today. Despite most forecasters expecting a steady if not catastrophic rise in joblessness this year, a flatlined CPI and a strengthening currency, the Riksbank chose to leave rates unchanged today. Note that this does notmean that monetary policy was unchanged. Quite the contrary, Swedish monetary policy was tightened meaningfully.

The Swedish central bank has on their Board one of the smartest monetary theorists in the world, Lars Svensson… and they are still failing.

Over in Japan, the central bank openly spits in the face of democracy, announcing today that they really do have every intention of ignoring the 2% inflation target set by Abe’s government:

For the time being, the year-on-year rate of change in the CPI is expected to turn negative due to the reversal of the previous year’s movements in energy-related and durable consumer goods, and thereafter, it is likely to be around 0 percent again.

Do I even need to mention the Eurozone? Here is Left Outside trying to contain his disgust at the ECB last month:

The Eurozone is blowing up. Unemployment is increasing across Europe and this is in large part because of contractionary policy from the ECB.

…

What they have not done, in a continent savaged by depression is cut fucking interest rates in the last six months. They have another 0.75% before they reach 0, but they are not willing to do so.

As normal, I felt like ranting and raving after watching Mervyn King speak at the Inflation Report press conference yesterday. But I’ll skip all that, it’s all been said. Yesterday the Bank (reluctantly) eased UK monetary policy, and that should be celebrated. The combined effect of Messrs Draghi, Bernanke, Abe and Carney has probably been more significant for the UK economy, but the Bank put the cherry on top.

All that “happened” yesterday was that the Bank of England held a press conference and published some documents. That’s all they “did”. They didn’t print any money. They didn’t fiddle about with interest rates; no “levers” were pulled. They just communicated. Here’s the WSJ:

Sterling dropped to a six-month low against the dollar Wednesday after Bank of England Governor Mervyn King said the Monetary Policy Committee is prepared to undertake more measures to stimulate the economy at a press conference following the release of the quarterly Inflation Report.

The pound weakened almost 1% against the dollar and traded as low as $1.5535, while it dropped 1.3% against the euro, which jumped to GBP0.8684. The selloff in sterling came after Mr. King said more needs to be done to stimulate external demand in the U.K. economy, hinting that more currency weakness would be helpful.

In the grand scheme of things, the change to the UK monetary policy was tiny – the Bank moved its forecasts of inflation up a few tens of basis points, and the Governor said he wouldn’t tighten policy in response. This tiny change was significant enough to knock 1% off Sterling. Imagine what “regime change” could do!

A monetary policy is not just the central bank doing something right now. A monetary policy is some sort of rule that tells the central bank the different things it should be doing under all sorts of different circumstances in the past, present, and future.

We have to think of monetary policy that way. First, because the effects of the central bank doing something right now, and whether those effects are good or bad, will depend on the circumstances. Second, and more importantly, what the central bank does right now isn’t the only thing that matters. What it did in the past matters too. And what it is expected to do in the future matters even more.

Some eyebrows have been raised after Mark Carney used the phrase “flexible inflation targeting” to describe the current UK monetary policy regime. I don’t think that should be a surprise, and I do think it’s correct to call the current regime “flexible inflation targeting”.

I keep saying it, but I think the source of confusion here is a failure to appreciate that inflation targeting is (and monetary policy generally can only be) forward-looking. Below I’ve quoted from a speech made by Mervyn King back in 1994 when he was merely the Bank of England Chief Economist, explaining this key point (after dismissing the need for an “intermediate” target for money supply growth alongside the formal inflation target):

The use of an inflation target does not mean that there is no intermediate target. Rather, the intermediate target is the expected level of inflation at some future date chosen to allow for the lag between changes in interest rates and the resulting changes in inflation. In practice, we use a forecasting horizon of two years. It is absolutely crucial to understand that the inflation target does not mean that policy is set according to the current rate of inflation.The latest inflation rate is relevant only in so far as it affects the projection for inflation some two years ahead.

My emphasis added. I can only hope that people read and re-read those last two sentences until the impact fully sinks in. To concentrate the mind, imagine that you are on the MPC in the Autumn of 2011, when the CPI rate is nearing 5%, and almost the entire press corps is berating you for printing too much money and being “too flexible” about the 2% target.

The policy regime King was following in 2011 is the same policy regime he was talking about in 1994, and that’s broadly the same regime that the Bank has followed every year since it gained independence in 1998.

King’s speech gives a standard explanation of flexible inflation targeting, or “inflation forecast-targeting”; where the monetary authority is flexible to the point of ambivalence about the current, observed rate of inflation. The Bank’s aim is to set policy such that its own forecast for inflation is at 2% at some point in the future. The Bank tends to use the two year horizon, although the MPC never specifies that precisely.

Flexibility Does Not Imply Discretion

I am rehashing an old post here, but this is where things get interesting. If you accept this interpretation of the current policy regime – be flexible about the current CPI rate, and keep the forecast of the CPI rate on target, we get a simple measure of the Bank’s policy stance: the deviation of forecast inflation from desired inflation.

To simplify a bit, I think it’s correct to say that “flexibility” in this specific sense does not involve the Bank exercising “discretion”; the choices the MPC make should be predictable and derive from the regime itself, plus their forecast model. A “neutral” policy stance should mean that Bank is always targeting 2% inflation.

If the Bank has set policy such that their forecast of inflation is not on target, they are exercising some kind of discretion, following a different policy than prescribed by the regime.

The chart below shows what the Bank’s own published data says about their policy stance over the last nine years under the 2% CPI target, showing the forecast for CPI inflation looking both two and three years forward, at each quarterly Inflation Report:

Median Forecasts for CPI Inflation on Two and Three Year Horizon. Source: BoE Inflation Report Forecast Data

This shows the significant variation in the median forecast on the two and three year horizon in recent years. Those two downward spikes in late 2008 and late 2011 are exceptional. The Bank was not targeting (i.e. had not set policy such that the forecast equals) 2% inflation on the two or three year horizons at those times. Why not? An obvious correlation is that current observed UK CPI inflation was very high, exceeding 5% in exactly those same time periods; late 2008 and late 2011.

In my opinion this is evidence of a discretionary, disinflationary bias in the MPC. Specifically, monetary policy has been almost continually “too tight” even if you accept that “target 2% inflation on the two year horizon” is the optimal policy regime. There are two obvious counter-arguments:

a) “The Bank is impotent at the ZLB. They can’t raise inflation whatever you say about their forecasts.”

b) “The Bank may be able to affect inflation and demand at the ZLB by printing money, but their forecasting model can’t capture the effects of QE so they are unable to make the forecast dependant on their actions.”

I think (a) is obviously false, but more importantly the Bank think it is false; otherwise they would not have done QE, stopped QE, started QE, etc, etc. This is also no excuse for the November 2008 forecasts being so far off target when interest rates were around or above 3% right across the yield curve, with no zero bound in sight.

(b) might actually be true, I’m not sure. If it is true, this is even stronger evidence of discretionary behaviour; the MPC has no basis on which to choose whether to do £100bn of QE or £50bn if they have no way to model how that money affects inflation and demand outcomes.

Back to the Future

The Inflation Report will be a fun one this week, and I’m looking forward to reading the minutes from this month’s MPC meeting. The unusual statement which accompanied the MPC decision implies their own forecasts have the CPI rate back above 2% on the two year horizon. The last time this happened was Spring of 2011 when the hawks were fighting to raise rates; the wording in the statement implies perhaps that the hawks have declared a cease fire. I’m using the language of discretion, here, of course.

I have to end this rambling post with an irresistible quote from Milton Friedman in 1960 which King used in his 1994 speech:

‘The failure of government to provide a stable monetary framework has thus been a major if not the major factor accounting for our really severe inflations and depressions’.

King gave his future self a get-out-of-jail-free card, insisting that “real shocks” can also have the same effect as bad monetary policy… a position which looks rather convenient for the UK’s top central banker in 2013. I’d bet future historians will go with Friedman.